Introduction to Corporate Finance

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GEORGE ZIMMER, FOUNDER of The Men’s Wearhouse, for years appeared in television ads promising “You’re going to like the way you look. I guarantee it.” But, in mid-2013, Zimmer evidently didn’t look so good to the company’s board of directors, which abruptly fired him. It was reported that Zimmer had a series of disagreements with the board, including a desire to take the company private. Evidently, Zimmer’s ideas did not “suit” the board.

Understanding Zimmer’s journey from the founder of a clothing store that used a cigar box as a cash register, to corporate executive, and finally to ex-employee takes us into issues involving the corporate form of organization, corporate goals, and corporate control, all of which we discuss in this chapter. You’re going to learn a lot if you read it. We guarantee it.

 

For updates on the latest happenings in finance, visit www.fundamentalsofcorporatefinance.blogspot.com.

Learning Objectives

After studying this chapter, you should understand:

LO1	The basic types of financial management decisions and the role of the financial manager.
LO2	The goal of financial management.
LO3	The financial implications of the different forms of business organization.
LO4	The conflicts of interest that can arise between managers and owners.

To begin our study of modern corporate finance and financial management, we need to address two central issues. First, what is corporate finance and what is the role of the financial manager in the corporation? Second, what is the goal of financial management? To describe the financial management environment, we consider the corporate form of organization and discuss some conflicts that can arise within the corporation. We also take a brief look at financial markets in the United States.

Page 21.1 Corporate Finance and the Financial Manager

In this section, we discuss where the financial manager fits in the corporation. We start by defining corporate finance and the financial manager’s job.

WHAT IS CORPORATE FINANCE?

Imagine that you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another:

1.  What long-term investments should you take on? That is, what lines of business will you be in and what sorts of buildings, machinery, and equipment will you need?

2.  Where will you get the long-term financing to pay for your investment? Will you bring in other owners or will you borrow the money?

3.  How will you manage your everyday financial activities such as collecting from customers and paying suppliers?

These are not the only questions by any means, but they are among the most important. Corporate finance, broadly speaking, is the study of ways to answer these three questions. Accordingly, we’ll be looking at each of them in the chapters ahead.

THE FINANCIAL MANAGER

A striking feature of large corporations is that the owners (the stockholders) are usually not directly involved in making business decisions, particularly on a day-to-day basis. Instead, the corporation employs managers to represent the owners’ interests and make decisions on their behalf. In a large corporation, the financial manager would be in charge of answering the three questions we raised in the preceding section.

The financial management function is usually associated with a top officer of the firm, such as a vice president of finance or some other chief financial officer (CFO). Figure 1.1 is a simplified organizational chart that highlights the finance activity in a large firm. As shown, the vice president of finance coordinates the activities of the treasurer and the controller. The controller’s office handles cost and financial accounting, tax payments, and management information systems. The treasurer’s office is responsible for managing the firm’s cash and credit, its financial planning, and its capital expenditures. These treasury activities are all related to the three general questions raised earlier, and the chapters ahead deal primarily with these issues. Our study thus bears mostly on activities usually associated with the treasurer’s office.

 

For current issues facing CFOs, see ww2.cfo.com.

FINANCIAL MANAGEMENT DECISIONS

As the preceding discussion suggests, the financial manager must be concerned with three basic types of questions. We consider these in greater detail next.

Capital Budgeting The first question concerns the firm’s long-term investments. The process of planning and managing a firm’s long-term investments is called capital budgeting. In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire. Loosely speaking, this means that the value of the cash flow generated by an asset exceeds the cost of that asset.

capital budgeting The process of planning and managing a firm’s long-term investments.

The types of investment opportunities that would typically be considered depend in part on the nature of the firm’s business. For example, for a large retailer such as Walmart, deciding whether to open another store would be an important capital budgeting decision. Similarly, for a software company such as Oracle or Microsoft, the decision to develop and market a new spreadsheet program would be a major capital budgeting decision. Some decisions, such as what type of computer system to purchase, might not depend so much on a particular line of business.

Page 3FIGURE 1.1 A Sample Simplified Organizational Chart

 

Regardless of the specific nature of an opportunity under consideration, financial managers must be concerned not only with how much cash they expect to receive, but also with when they expect to receive it and how likely they are to receive it. Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting. In fact, as we will see in the chapters ahead, whenever we evaluate a business decision, the size, timing, and risk of the cash flows will be by far the most important things we will consider.

Capital Structure The second question for the financial manager concerns ways in which the firm obtains and manages the long-term financing it needs to support its long-term investments. A firm’s capital structure (or financial structure) is the specific mixture of long-term debt and equity the firm uses to finance its operations. The financial manager has two concerns in this area. First, how much should the firm borrow? That is, what mixture of debt and equity is best? The mixture chosen will affect both the risk and the value of the firm. Second, what are the least expensive sources of funds for the firm?

capital structure The mixture of debt and equity maintained by a firm.

Page 4If we picture the firm as a pie, then the firm’s capital structure determines how that pie is sliced—in other words, what percentage of the firm’s cash flow goes to creditors and what percentage goes to shareholders. Firms have a great deal of flexibility in choosing a financial structure. The question of whether one structure is better than any other for a particular firm is the heart of the capital structure issue.

In addition to deciding on the financing mix, the financial manager has to decide exactly how and where to raise the money. The expenses associated with raising long-term financing can be considerable, so different possibilities must be carefully evaluated. Also, corporations borrow money from a variety of lenders in a number of different, and sometimes exotic, ways. Choosing among lenders and among loan types is another job handled by the financial manager.

Working Capital Management The third question concerns working capital management. The term working capital refers to a firm’s short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers. Managing the firm’s working capital is a day-to-day activity that ensures that the firm has sufficient resources to continue its operations and avoid costly interruptions. This involves a number of activities related to the firm’s receipt and disbursement of cash.

working capital A firm’s short-term assets and liabilities.

Some questions about working capital that must be answered are the following: (1) How much cash and inventory should we keep on hand? (2) Should we sell on credit? If so, what terms will we offer, and to whom will we extend them? (3) How will we obtain any needed short-term financing? Will we purchase on credit, or will we borrow in the short term and pay cash? If we borrow in the short term, how and where should we do it? These are just a small sample of the issues that arise in managing a firm’s working capital.

Conclusion The three areas of corporate financial management we have described—capital budgeting, capital structure, and working capital management—are very broad categories. Each includes a rich variety of topics, and we have indicated only a few questions that arise in the different areas. The chapters ahead contain greater detail.

Concept Questions

1.1a   What is the capital budgeting decision?

1.1b   What do you call the specific mixture of long-term debt and equity that a firm chooses to use?

1.1c   Into what category of financial management does cash management fall?

1.2 Forms of Business Organization

Large firms in the United States, such as Ford and Microsoft, are almost all organized as corporations. We examine the three different legal forms of business organization—sole proprietorship, partnership, and corporation—to see why this is so. Each form has distinct advantages and disadvantages for the life of the business, the ability of the business to raise cash, and taxes. A key observation is that as a firm grows, the advantages of the corporate form may come to outweigh the disadvantages.

SOLE PROPRIETORSHIP

A sole proprietorship is a business owned by one person. This is the simplest type of business to start and is the least regulated form of organization. Depending on where you live, you might be able to start a proprietorship by doing little more than getting a business license and opening your doors. For this reason, there are more proprietorships than any other type of business, and many businesses that later become large corporations start out as small proprietorships.

sole proprietorship A business owned by a single individual.

Page 5The owner of a sole proprietorship keeps all the profits. That’s the good news. The bad news is that the owner has unlimited liability for business debts. This means that creditors can look beyond business assets to the proprietor’s personal assets for payment. Similarly, there is no distinction between personal and business income, so all business income is taxed as personal income.

The life of a sole proprietorship is limited to the owner’s life span, and the amount of equity that can be raised is limited to the amount of the proprietor’s personal wealth. This limitation often means that the business is unable to exploit new opportunities because of insufficient capital. Ownership of a sole proprietorship may be difficult to transfer because this transfer requires the sale of the entire business to a new owner.

PARTNERSHIP

A partnership is similar to a proprietorship except that there are two or more owners (partners). In a general partnership, all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share. The way partnership gains (and losses) are divided is described in the partnership agreement. This agreement can be an informal oral agreement, such as “let’s start a lawn mowing business,” or a lengthy, formal written document.

partnership A business formed by two or more individuals or entities.

In a limited partnership, one or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who will not actively participate in the business. A limited partner’s liability for business debts is limited to the amount that partner contributes to the partnership. This form of organization is common in real estate ventures, for example.

The advantages and disadvantages of a partnership are basically the same as those of a proprietorship. Partnerships based on a relatively informal agreement are easy and inexpensive to form. General partners have unlimited liability for partnership debts, and the partnership terminates when a general partner wishes to sell out or dies. All income is taxed as personal income to the partners, and the amount of equity that can be raised is limited to the partners’ combined wealth. Ownership of a general partnership is not easily transferred because a transfer requires that a new partnership be formed. A limited partner’s interest can be sold without dissolving the partnership, but finding a buyer may be difficult.

Because a partner in a general partnership can be held responsible for all partnership debts, having a written agreement is very important. Failure to spell out the rights and duties of the partners frequently leads to misunderstandings later on. Also, if you are a limited partner, you must not become deeply involved in business decisions unless you are willing to assume the obligations of a general partner. The reason is that if things go badly, you may be deemed to be a general partner even though you say you are a limited partner.

Based on our discussion, the primary disadvantages of sole proprietorships and partnerships as forms of business organization are (1) unlimited liability for business debts on the part of the owners, (2) limited life of the business, and (3) difficulty of transferring ownership. These three disadvantages add up to a single, central problem: the ability of such businesses to grow can be seriously limited by an inability to raise cash for investment.

CORPORATION

The corporation is the most important form (in terms of size) of business organization in the United States. A corporation is a legal “person,” separate and distinct from its owners, and it has many of the rights, duties, and privileges of an actual person. Corporations can borrow money and own property, can sue and be sued, and can enter into contracts. A corporation can even be a general partner or a limited partner in a partnership, and a corporation can own stock in another corporation.

corporation A business created as a distinct legal entity composed of one or more individuals or entities.

Page 6Not surprisingly, starting a corporation is somewhat more complicated than starting the other forms of business organization. Forming a corporation involves preparing articles of incorporation (or a charter) and a set of bylaws. The articles of incorporation must contain a number of things, including the corporation’s name, its intended life (which can be forever), its business purpose, and the number of shares that can be issued. This information must normally be supplied to the state in which the firm will be incorporated. For most legal purposes, the corporation is a “resident” of that state.

The bylaws are rules describing how the corporation regulates its existence. For example, the bylaws describe how directors are elected. These bylaws may be a simple statement of a few rules and procedures, or they may be quite extensive for a large corporation. The bylaws may be amended or extended from time to time by the stockholders.

In a large corporation, the stockholders and the managers are usually separate groups. The stockholders elect the board of directors, who then select the managers. Managers are charged with running the corporation’s affairs in the stockholders’ interests. In principle, stockholders control the corporation because they elect the directors.

As a result of the separation of ownership and management, the corporate form has several advantages. Ownership (represented by shares of stock) can be readily transferred, and the life of the corporation is therefore not limited. The corporation borrows money in its own name. As a result, the stockholders in a corporation have limited liability for corporate debts. The most they can lose is what they have invested.

The relative ease of transferring ownership, the limited liability for business debts, and the unlimited life of the business are why the corporate form is superior for raising cash. If a corporation needs new equity, for example, it can sell new shares of stock and attract new investors. Apple is an example. The company was a pioneer in the personal computer business. As demand for its products exploded, it had to convert to the corporate form of organization to raise the capital needed to fund growth and new product development. The number of owners can be huge; larger corporations have many thousands or even millions of stockholders. For example, in 2014, General Electric Company (better known as GE) had about 4 million stockholders and about 10.1 billion shares outstanding. In such cases, ownership can change continuously without affecting the continuity of the business.

The corporate form has a significant disadvantage. Because a corporation is a legal person, it must pay taxes. Moreover, money paid out to stockholders in the form of dividends is taxed again as income to those stockholders. This is double taxation, meaning that corporate profits are taxed twice: at the corporate level when they are earned and again at the personal level when they are paid out.1

Today, all 50 states have enacted laws allowing for the creation of a relatively new form of business organization, the limited liability company (LLC). The goal of this entity is to operate and be taxed like a partnership but retain limited liability for owners, so an LLC is essentially a hybrid of partnership and corporation. Although states have differing definitions for LLCs, the more important scorekeeper is the Internal Revenue Service (IRS). The IRS will consider an LLC a corporation, thereby subjecting it to double taxation, unless it meets certain specific criteria. In essence, an LLC cannot be too corporation-like, or it will be treated as one by the IRS. LLCs have become common. For example, Goldman, Sachs and Co., one of Wall Street’s last remaining partnerships, decided to convert from a private partnership to an LLC (it later “went public,” becoming a publicly held corporation). Large accounting firms and law firms by the score have converted to LLCs.

Page 7TABLE 1.1 Intemational Corporations

 

As the discussion in this section illustrates, the need of large businesses for outside investors and creditors is such that the corporate form will generally be the best for such firms. We focus on corporations in the chapters ahead because of the importance of the corporate form in the U.S. and world economies. Also, a few important financial management issues, such as dividend policy, are unique to corporations. However, businesses of all types and sizes need financial management, so the majority of the subjects we discuss bear on any form of business.

A CORPORATION BY ANOTHER NAME …

The corporate form of organization has many variations around the world. The exact laws and regulations differ from country to country, of course, but the essential features of public ownership and limited liability remain. These firms are often called joint stock companies, public limited companies, or limited liability companies, depending on the specific nature of the firm and the country of origin.

Table 1.1 gives the names of a few well-known international corporations, their countries of origin, and a translation of the abbreviation that follows the company name.

Concept Questions

1.2a   What are the three forms of business organization?

1.2b   What are the primary advantages and disadvantages of sole proprietorships and partnerships?

1.2c   What is the difference between a general and a limited partnership?

1.2d   Why is the corporate form superior when it comes to raising cash?

1.3 The Goal of Financial Management

Assuming that we restrict ourselves to for-profit businesses, the goal of financial management is to make money or add value for the owners. This goal is a little vague, of course, so we examine some different ways of formulating it to come up with a more precise definition. Such a definition is important because it leads to an objective basis for making and evaluating financial decisions.

Page 8POSSIBLE GOALS

If we were to consider possible financial goals, we might come up with some ideas like the following:

Survive.

Avoid financial distress and bankruptcy.

Beat the competition.

Maximize sales or market share.

Minimize costs.

Maximize profits.

Maintain steady earnings growth.

These are only a few of the goals we could list. Furthermore, each of these possibilities presents problems as a goal for the financial manager.

For example, it’s easy to increase market share or unit sales: All we have to do is lower our prices or relax our credit terms. Similarly, we can always cut costs simply by doing away with things such as research and development. We can avoid bankruptcy by never borrowing any money or never taking any risks, and so on. It’s not clear that any of these actions are in the stockholders’ best interests.

Profit maximization would probably be the most commonly cited goal, but even this is not a precise objective. Do we mean profits this year? If so, we should note that actions such as deferring maintenance, letting inventories run down, and taking other short-run cost-cutting measures will tend to increase profits now, but these activities aren’t necessarily desirable.

The goal of maximizing profits may refer to some sort of “long-run” or “average” profits, but it’s still unclear exactly what this means. First, do we mean something like accounting net income or earnings per share? As we will see in more detail in the next chapter, these accounting numbers may have little to do with what is good or bad for the firm. Second, what do we mean by the long run? As a famous economist once remarked, in the long run, we’re all dead! More to the point, this goal doesn’t tell us what the appropriate trade-off is between current and future profits.

The goals we’ve listed here are all different, but they tend to fall into two classes. The first of these relates to profitability. The goals involving sales, market share, and cost control all relate, at least potentially, to different ways of earning or increasing profits. The goals in the second group, involving bankruptcy avoidance, stability, and safety, relate in some way to controlling risk. Unfortunately, these two types of goals are somewhat contradictory. The pursuit of profit normally involves some element of risk, so it isn’t really possible to maximize both safety and profit. What we need, therefore, is a goal that encompasses both factors.